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BOND VALUATION CONCEPTS

BOND VALUATION CONCEPTS . FIN 3403, 3404 PROF. DIGGLE. BOND CONCEPTS. What is a bond? How do corporate bonds differ from other kinds of bonds? Priority of claim pyramid Characteristics of Corporate bonds What is a Municipal bond? Characteristics of muny bonds. RISK VS RETURN.

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BOND VALUATION CONCEPTS

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  1. BOND VALUATION CONCEPTS FIN 3403, 3404 PROF. DIGGLE

  2. BOND CONCEPTS • What is a bond? • How do corporate bonds differ from other kinds of bonds? • Priority of claim pyramid • Characteristics of Corporate bonds • What is a Municipal bond? • Characteristics of muny bonds.

  3. RISK VS RETURN • KINDS OF RISK--RECAP • INFLATION RISK • BUSINESS OR DEFAULT RISK • MARKET RISK • LIQUIDITY RISK • INTR. RATE RISK • OTHER • CURRENCY RISK • POLITICAL RISK • ETC.

  4. TERMS PAR COUPON RATE DOLLAR ANNUAL COUPON CURRENT YIELD YIELD TO MATURITY INDENTURE DEBENTURE DURATION ACCRUED INTEREST CONCEPTS IF INTEREST RATES RISE WHAT HAPPENS TO BOND PRICES? Current yield vs. YTM BOND CONCEPTS AND TERMS (see lec notes p. 34)

  5. THE BOND TVM TIME LINE COUPON COUPON COUPON COUPON COUPON ETC ETC All bonds we will study pay SEMI-ANNUALLY (coupon every 6 months) An 8% bond pays two coupons of $40 each A 30 year bond has 60 interest coupons. PAR AT MATURITY ($1000)

  6. A BOND IS IN TWO PARTS: PRINCIPAL ($1000 PAR) -- LUMP SUM AT MATURITY INTEREST coupons (SEMIANNUAL) (ANNUITY) The value of a bond is the NPV of both elements The price of a bond is, therefore, another TVM problem. What is the discount rate? The current MARKET rate of bonds of similar TYPE, QUALITY and MATURITY BOND VALUATIONSEE LEC NOTES PP. 35-38

  7. U.S. GOVERNMENT U.S. TREASURY Treasury series EE U.S. AGENCY MUNICIPAL CORPORATE Mortgage Debenture FOREIGN GOVT. TAX CONSIDERATIONS The Tax Equivalent yield ZERO COUPON BONDS STRIPS INFLATION ADJUSTED BONDS KINDS OF BONDS

  8. ALL new corporate bond issues are subject to SEC review The Indenture Role of the Bond Trustee How is a bond sold The “Shelf registration” What terms are in the Indenture? Collateral and priority of claim Coupon in percent and dollars Maturity Call provisions sinking fund redemption Trustee CORPORATE BONDSIssued by domestic corporations

  9. MOODY’S AND STANDARD AND POOR RATING FROM AAA (best) to BA (lowest “investment” grade), to below B (“junk bonds.” The bond rating is a measure of business risk or risk of default only. Corporations and municipalities must pay a fee to have bonds rated. Therefore many bonds are NR. BOND “RATING” SERVICES

  10. MUNY BONDSBonds issued by states, cities and local authorities like airports • GO or General Obligation (supported usually by real estate taxes) • REVENUE AND IDR • HOW DOES A CORPORATION DO AN IDR? • SINGLE, DOUBLE AND TRIPLE TAX FREE MUNYS • WHY ARE MUNY’S FREE OF FEDERAL INCOME TAX?

  11. YTM is the “Total Return” on a bond. This consists of: CURRENT YIELD CAPITAL GAINS “YIELD” If a bond is selling at a PREMIUM (above par), bondholder will have a capital loss to maturity. If a bond is selling at a DISCOUNT, you have a guaranteed capital gain to maturity. PREMIUM: CURRENT YIELD > THAN YTM WHY? DISCOUNT CURRENT YIELD < YTM. WHY? YIELD TO MATURITY

  12. You buy a corporate bond on 12-1-98 The coupon is 7.5% The bond matures on May 15, 2015 (Millennium problem does not affect calculator) The market yield is 6%. Compute PRICE THIS IS SDT $75 PER YEAR or $37.50 per coupon Matures at par. Par is expressed in % in your calculator. Therefore $1000 par is entered as 100 or 100% YLD = 6 BOND PROELEM USING YOUR CALCULATOR

  13. SDT enter 12.0198 CPN enter 7.5 RDT enter 5.1515 RV = 100% OF PAR OR $1000 ACT (for corporates) and 360 for Treasuries 2/Y (semiannual pay) LEAVE YOUR TI BA2 AT ACT AND 2/Y YLD = market yield on bonds of similar type, quality and maturity = 6 SOLVE FOR PRI (price -- push CPT) MAY ALSO SOLVE FOR YTM where price is given AI = accrued interest TIBA 2+ CALCULATOR BOND WORKSHEET

  14. WHAT DOES THE BOND WORKSHEET DO? • THE PRICE OF A BOND IS THE NET PRESENT VALUE OF: • THE LUMP SUM OF $1000 PAR RECEIVED AT MATURITY • THE ANNUITY OF COUPON INTEREST RECEIVED SEMIANNUALLY OVER REMAINING LIFE OF BOND (P/Y = 2) • HOW WOULD YOU COMPUTE THE PRICE OF A ZERO COUPON BOND?

  15. Why would a company or municipality call a bond? Why do investors dislike callable bonds? If a bond is not callable for 5 years this is called call protection. REDEMPTION CALL SINKING FUND CALL CALCULATING YIELD TO CALL ON YOUR CALCULATOR ACCRUED INTEREST WHAT IS CALL?

  16. A. YOU BUY A BOND TODAY MATURING IN 30 YEARS. YOU PAY 1030 (103% of par) THE COUPON IS 7.33% WHAT IS THE YIELD TO MATURITY? B. YOU BUY A BOND TODAY MATURING IN 25 YEARS THAT IS CALLABLE IN 15 YEARS AT 105 ALL FACTS ON LEFT SIDE ARE THE SAME. COMPUTE YIELD TO CALL. BOND PROBLEM

  17. SEE TEXT MATURITY IS A FIXED DATE IN TIME DURATION IS A MEASURE OF BOND CASH FLOW COMBINING MATURITY AND COUPON INCOME A HIGH COUPON BOND WILL HAVE A SHORTER DURATION THAN A LOWER COUPON ISSUE THAT IS IDENTICAL IN ALL OTHER RESPECTS DURATION VS MATURITY

  18. You buy a bond on March 10. Coupons are paid on Jan 1 and June 30. What is the accrued income? Who pays it and why? Accrued income is added to the amount received by the SELLER Who will receive the June 30 coupon? THE BUYER. The buyer must pay the seller accrued interest for the time he owned the bond since the last coupon. This is done on settlement date. ACCRUED INTEREST

  19. Corporate securities settle in 3 business days after trade date. You buy a bond on Friday. Monday is a Holiday. When is corporate settlement? This is when good funds must be available to pay for bond or stock. Government (TREASURY) bonds are next day settlement (next business day). SDT on your financial calculator is settlement date. RDT (redemption date) is maturity or call date. TRADE DATE AND SETTLEMENT DATE

  20. A convert is a bond with additional contractual provisions in the indenture providing for conversion of the bond into common stock. A convert is “Quasi Equity.” It behaves like common stock. TERMINOLOGY CONVERSION PRICE CONVERSION RATIO THEORETICAL VALUE PREMIUM OVER THEORETICAL VALUE CONVERTS & ZEROS: FIN 3404--FIN 3404 STUDENTS not responsible

  21. Why would a company include convertibility as a “sweetener” in the indenture? What happens if a convertible bond is called by the company? 2 situations Are converts a good investment? Why or why not? Should you buy a callable convert selling above call price? Why or why not? CONVERTS CONTD.

  22. A convert is convertible into 20 shares of common. This is the conversion ratio. This means the conversion price is $50 ($1000 par / 20) When a convert is issued, the conversion price is usually 15% or so below common price. Why? Assume the common price is $40 when the bond is floated. CONVERT PROBLEM

  23. Assume now it is 3 years later and the common is selling for $65 per share. What is the theoretical value of the convert? Conv ratio = number of common shares per bond X stock price TV = 20 x $65 = $1300 Assume the call price set in the indenture is 103 ($1030). What happens if this bond is called? CONVERT PROBLEM CONTD

  24. Why do most converts sell at a PREMIUM over conversion or theoretical value? Priority of claim Current yield on bond vs dividend yield on stock Say the bond we are looking at carried a coupon of 8%. The burrent yield at a price of $1300 = 6.15%. Assume the common dividend is $2.00. The dividend yield is 2/65 or 3.1%. Which would you rather own? CONVERTS CONTD

  25. Bond in which coupons have been stripped off. Price is simply the NPV of the par value ($1000) at maturity. What reasons can you think of for investors to own zero coupon treasuries? Compute the price of a Treasury maturing in 30 years when the yield on coupon conds of similar type and quality is 6.4% WHAT ARE ZERO COUPON BONDS?

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